As a result of the Delaware Court of Chancery’s decision last year in Cigna Health and Life Insurance Co. v. Audax Health Solutions, Inc.,1 potential buyers in private merger and acquisition transactions are facing a significant challenge in securing the protections once commonly available to them in private mergers in the absence of a separate agreement with the individual shareholders. Cigna disrupted the ability of buyers to obtain indemnification (other than pursuant to an escrow or holdback) and to require selling shareholders to be bound by the decisions of a stockholder’s representative. It also called into question the validity of claim releases by the target company’s shareholders. Further, a letter of transmittal or other agreement for which the stockholders do not receive additional consideration cannot be used to impose these requirements even if the requirements are explicitly included in the terms of the merger agreement.
While there have been many suggestions about how buyers should address the issues raised by Cigna, including use of joinder agreements as a closing condition or avoiding mergers for stock purchases, drag rights if available, larger escrows, or reductions in purchase price, these solutions are often impractical as they increase deal risk and holdup value, result in timing delays, offer insufficient protection, create moral hazards and/or have significant negative value impact on the selling shareholders. What is needed is an alternative approach that restores the economic risk allocation that was available pre-Cigna without imposing deal risk, timing delays or reducing value while respecting Cigna’s conclusions regarding the statutory requirements for mergers under the Delaware General Corporation Law.
A hybrid solution would require incentives under the merger agreement for shareholders to sign joinder agreements that would allow the buyer to enforce the bargained-for allocation of risk and other obligations, while not making the transaction less attractive to the company and its shareholders than a pre-Cigna structure. The solution lies in reframing the consideration (or the portion thereof equal to the highest indemnification cap and after a separate reduction for a customary and separate escrow fund or holdback) to be paid to each shareholder as a grant of non-transferable rights to receive payment from a separate escrow or holdback after some significant period (e.g., six years). Such separate escrow or holdback would be a way to secure the indemnification obligations set forth in the merger agreement (after any traditional holdback or escrow has been expended or is otherwise unavailable) and would allow individual shareholders to accelerate the cash payment or their pro rata portion of such separate escrow or holdback upon the execution of a joinder agreement by the applicable shareholder. This approach allows buyers and target companies to execute merger agreements without requiring that all shareholders become parties pre-closing, creates a significant incentive for shareholders to execute joinders giving the buyer the protections negotiated with the target company and does not impose on shareholders obligations or barriers to receiving their consideration that were not considered common before Cigna.
The Cigna Decision
In February 2014, Optum Services, Inc. (“Optum”) and Audax Health Solutions, Inc. (“Audax”) entered into a merger agreement under which Optum would acquire Audax via a reverse triangular merger. Over two-thirds of Audax’s shareholders approved the merger in a non-unanimous written consent. The merger agreement contained provisions conditioning payment of each shareholder’s portion of the merger consideration upon such shareholder executing a letter of transmittal and surrendering its shares. The letters of transmittal contained a general release of claims against Optum (the details of which were not contained in the merger agreement) and a provision agreeing to the appointment of the shareholders’ representative. The merger agreement also required shareholders to indemnify Optum up to the full amount of their share of the merger consideration for certain breaches of the merger agreement.
At the time, Cigna Health and Life Insurance Co. (“Cigna”) was a shareholder of Audax. Cigna did not consent to the merger, did not execute a support agreement, and did not execute its letter of transmittal. Optum in turn refused to pay Cigna its portion of the merger consideration in accordance with the terms of the merger agreement. Cigna brought suit, arguing that the letter of transmittal (including the general release and shareholders’ representation appointment) was unenforceable for a lack of consideration. Cigna further argued that the shareholder indemnification provision in the merger agreement violated Section 251(b) of the Delaware General Corporation Law (the “DGCL”). Section 251(b) of the DGCL requires that a merger agreement clearly state “the cash, property, rights or securities of any other corporation or entity which the holders of such shares are to receive.” Cigna argued that because certain of the indemnification obligations extended indefinitely and were capped only at each shareholder’s share of the merger consideration, each shareholder could never definitely determine the consideration they received under the merger.
The court agreed with Cigna and held that the letter of transmittal was unenforceable for lack of consideration. Pointing to the language of Section 251 of the DGCL, the court found that Cigna’s right to receive its share of the merger consideration vested at the effective time of the merger.2 Because the letter of transmittal was to be executed after the effective time of the merger, the court held that the letter of transmittal was not supported by consideration (even though the merger agreement conditioned receipt of the merger consideration upon execution of the letter of transmittal).3 As the letter of transmittal was not supported by consideration, Optum could not enforce its general release contained therein.4
The court further agreed with Cigna regarding its interpretation of Section 251(b) of the DGCL. The court reasoned that because Cigna could be required to pay back all or none of its share of the merger consideration at any time, its consideration was not reasonably ascertainable.5 Therefore, the court held the indemnification obligations contained in the merger agreement unenforceable.6 However, Cigna made clear that its holding did not concern escrow agreements and the court repeatedly distinguished a claw back indemnification right from an escrow arrangement.7
After Cigna, questions remain whether indemnification obligations which are not unlimited in duration or are capped at an amount less than the purchase price are still enforceable. Moreover, the court made clear that additional obligations contained in letters of transmittal to be signed post-closing are unenforceable due to the lack of consideration above and beyond the merger consideration to which shareholders are already entitled post-closing.8 Because a letter of transmittal is often the only document a non-consenting shareholder signs, the court’s holdings have made it more difficult for buyers to reduce their risks in private mergers by limiting their ability to utilize releases against non-consenting shareholders. Coupled with the questions the Cigna holding raises regarding the availability of long-term or uncapped shareholder indemnification the court’s invalidation of the risk reducing provisions in the letter of transmittal may cause future merger to become a riskier endeavor.
Proposed Solutions and their Consequences
Four approaches have emerged as the first round of solutions proposed to resolve the issues raised by Cigna: (a) lower purchase prices, (b) increased holdbacks, (c) avoiding mergers altogether and (d) the use of closing conditions requiring all or certain shareholders to enter joinder agreements containing the desired protections.
Lower Purchase Prices. Lower purchase prices can compensate buyers for the increased risk they face in light of their inability to obtain indemnification and release of claims from non-consenting shareholders. While buyers save money upfront with a reduced purchase price, the risk is difficult to price and the target company and shareholders have an informational advantage and perverse incentive to prefer price reductions when likely indemnification claims would exceed the purchase price reduction. Lower purchase prices can also lead to moral hazard issues as a company whose shareholders have limited or no indemnification obligations may choose to take actions to maximize price or closing certainty but that breach the agreement or hurt the value of the company. Moreover, due to the difficulty in quantifying this increased risk, the amount of any purchase price reduction can be difficult to negotiate. Without adequate support for the lower numbers, target companies may view such prices as at best undesirable and at worst arbitrary and unfair. Lower purchase prices also have a negative effect on all shareholders, including those willing to provide indemnification and releases through joinder or other agreements. Without a method to separate out these low risk persons from the non-consenting shareholders, a smaller purchase price harms all shareholders equally.
Increased Holdbacks. Increased holdbacks or escrows are similarly undesirable. Buyers would again need to quantify the risks of shareholder litigation to justify the amount of the increased holdback (particularly the size of the holdback required to cover the highest indemnification cap). Again, without a means to reveal low risk persons from the other shareholders, the holdbacks would apply to all shareholders pro rata. Shareholders who would otherwise agree to indemnification and general releases, knowing that they are at a low risk of being sued for breach of the contract or wanting to sue the company outside of the contract, would receive no additional benefit to counterbalance the additional burden of the holdback.
Avoiding the Merger Structure. In practice, the merger structure is often utilized to avoid holdouts or when the number of stockholders makes a stock purchase agreement otherwise impractical or is undesirable for pre-signing confidentiality or other reasons. Thus, avoiding mergers altogether is at best a situational solution and will not work for every transaction. Instead, a solution is needed that does not eliminate the benefits of a merger structure.
Closing Conditions. The use of closing conditions that require all shareholders to sign joinder agreements most closely approximates the protections thought available before Cigna. Buyers can negotiate a closing condition in the merger agreement that all or a certain number of shareholders enter into joinder agreements binding shareholders to indemnification provisions, appointment of the shareholder representative, general releases of claims and other provisions of the merger agreement applicable to shareholders. Because the holding in Cigna casts doubt on whether non-consenting shareholders can be bound to indemnification obligations contained in the merger agreement alone, including the desired indemnification and releases in both the merger agreement and joinder agreements is best practice. Incentivizing shareholders to enter into joinder agreements poses the key problem to this approach, the feasibility of which declines as the total number of shareholders rises. Buyers can condition the closing upon receipt of signed joinder agreements from all shareholders but shareholder inactivity and the opportunity for holdouts from shareholders looking to obtain additional concessions can bog down the closing process. Closing over the condition can remedy any holdout, but as the court in Cigna makes clear, obligations imposed for the first time post-closing cannot be enforced unless the buyer provides additional consideration beyond the merger consideration. As such, without additional consideration, the protections afforded in the joinder agreement and merger agreement may be found unenforceable against such shareholders. Furthermore, requiring all shareholders to sign joinders as a closing condition increases deal risk and delays closing, thus making the transaction less desirable to the target company and the buyer.
Incentivizing Shareholders to Sign Joinders through an Accelerable Escrow Payment Right
For the buyer, having shareholders enter into joinder agreements after the merger agreement is signed affords the buyer the same types of protections thought available prior to Cigna. However, because shareholders are statutorily entitled to their share of the merger consideration once the merger closes, additional agreements entered into post-closing between shareholders and the buyer must be supported by additional consideration. Moreover, shareholders willing to hold out in the pre-closing period can potentially gain a great deal of leverage over the deal. Therefore, each shareholder has little incentive to enter into a joinder agreement when it anticipates that the parties will consummate the merger even if such shareholder does not sign. Effectively incentivizing shareholders to enter into joinder agreements becomes the key to restoring the pre-Cigna landscape for buyers.
Incentivizing shareholders to enter into joinder agreements can be difficult when each is entitled to their share of the merger consideration upon closing whether they enter into a joinder or not. However, the utilization of a right allowing the stockholder to accelerate payments held in an escrow upon the completion of certain conditions can remedy the problem of shareholder incentives. Private merger agreements can be drafted such that the merger consideration itself takes the form of a non-transferable, non-certificated right that entitles shareholders to their pro-rata share of a separate escrow or holdback (in addition to any traditional escrows or holdbacks for the transaction) after a set number of years (the “Accelerable Escrow Payment Right”). However, each shareholder’s Accelerable Escrow Payment Right would also separately grant each shareholder the right to receive their pro-rata share of the escrow or holdback within a small number of business days upon such shareholder executing a joinder agreement in a form agreed between buyer and the target company and attached to the merger agreement. By including the desired protections in the joinder, buyers are protected in much the same manner they were beforeCigna.
Moreover, such an approach may lead to better results for most shareholders of the target company as well. This convertible interest contains a self-selecting means of separating shareholders who provide some risk to the company post-closing and those that do not. Those shareholders who know that they present little risk to the company post-closing would be willing to sign the joinder agreement and receive their money right away, while the consideration is effectively held back from those individuals unwilling to sign joinders (signaling that they may consider future litigation or breach of the agreement). The convertible interest also solves the problem of shareholder holdouts as consummation of the merger can occur before all joinder agreements have been executed. Based on the incentives imposed through the Accelerable Escrow Payment Right, a buyer can consider lesser or no closing conditions relating to joinder agreements, reducing deal risk and closing delays. Furthermore, unlike the situation in Cigna, any obligations newly imposed post-merger in the joinder agreements will not be held invalid for lack of consideration because in exchange for execution of the joinder agreements the shareholder receives within a few business days a payment that it might not otherwise receive for years.
Restoring the Balance: Protecting Buyers and not Imposing Undue Delays or Reductions on Selling Shareholders
The Delaware Court of Chancery’s decision in Cigna shook up the private M&A practice of including individual shareholder obligations (such as indemnity obligations) in letters of transmittal executed post-closing. Due to the court’s holding, practitioners have been charged with inventing a means of restoring the buyer’s pre-Cigna private M&A toolkit. Use of the Accelerable Escrow Payment Right should be considered by buyers as a means of retaining the protections and flexibility previously available to them in private mergers while avoiding the deal risks, value reductions or delays created by many of the first generation of solutions for Cigna.